The Manipulations People Play

If a market can be abused, it will be abused. There are players in every market who are motivated by greed and willing to bend or break rules if they can get away with it.

To illustrate this point, let's go back in time to the Enron scandal. A former Enron employee described to me in detail how certain traders manipulated the wholesale power market after deregulation in California in 1996. There are parallels here to current manipulation in the stock market.

As this former Enron employee explained, traders would aggressively "stress test" regulations, looking for "regulatory holes" that they could exploit. If one regulatory hole did not work, they would try another, and then another. They would keep trying until they could find a way to profitably game the system.

In particular, traders focused their sights on manipulating supply in the deregulated California market. That's because demand is difficult to manipulate.

At the time, demand for power was growing steadily in California at a mid-single-digit annual rate. But prices for power rocketed higher by tenfold in a short period of time. How did this happen?

Power was manipulated in California by intentionally withholding supply, by creating a volatile spot market, by shutting down perfectly working generators and by intentionally creating congestion in power lines -- and then relieving that congestion for a fee. This last strategy was called "Death Star" by traders. One trader commented, in public record audiotapes, that he always looked at a power line to see if he could "congest it." He said, "If you can congest it, that's a moneymaker."

When there are problems in a market, such as the power market or the stock market, lawmakers try to solve the problem with new regulations. The regulations are promulgated with good intentions.

Traders who are motivated by greed have the opposite intentions. As one Reliant Energy (RRI - commentary - Cramer's Take) trader said on another audiotape that became public record after the California market manipulation came to light, "You know when we might follow rules? If there's some penalty ... if it's economics, it's economics, and by God, that's what rules."

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At time of publication, Alsin and/or ACM was long Microsoft and Overstock, although holdings can change at any time.

Arne Alsin is the founder and principal of Alsin Capital Management, an Oregon-based investment advisor, and portfolio manager of The Turnaround Fund, a no-load mutual fund. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Alsin appreciates your feedback; click here to send him an email.